General Theory Of Employment

Treatise On Probability

John Maynard Keynes

John Maynard Keynes (right) and Harry Dexter White at the Bretton Woods Conference

John Maynard Keynes, 1st Baron Keynes, CB (pronounced "canes", IPA /keɪnz/) (5 June 1883 – 21 April 1946) was a British economist whose ideas, called Keynesian economics, had a major impact on modern economic and political theory as well as on many governments' fiscal policies. He is particularly remembered for advocating interventionist government policy, by which the government would use fiscal and monetary measures to aim to mitigate the adverse effects of economic recessions, depressions and booms. Economists consider him one of the main founders of modern theoretical macroeconomics. His popular expression "In the very long run we are all dead" is still quoted.

Biography

Personal and marital life

John Maynard Keynes was the son of John Neville Keynes, an economics lecturer at Cambridge University, and Florence Ada Brown, a successful author and a social reformist. His younger brother Geoffrey Keynes (1887-1982) was a surgeon and bibliophile and his younger sister Margaret (1890-1974), married the Nobel-prize winning physiologist Archibald Hill.

Keynes was very tall, standing at approximately 6' 6" (198 cm). He had a serious relationship with the Bloomsbury painter Duncan Grant from 1908 to 1915. He continued to assist Grant financially for the rest of his life. Keynes met Lydia Lopokova, a well-known Russian ballerina, in October 1918. The two married and, by most accounts, Keynes enjoyed a happy marriage with Lopokova. For medical reasons, they were unable to have children, though both his siblings had children of note.

Keynes was ultimately a successful investor, building up a substantial private fortune. He was nearly wiped out following the Stock Market Crash of 1929 but soon recouped his fortunes. He enjoyed collecting books; during his lifetime, for example, he collected and protected many of Isaac Newton's papers. He was interested in literature in general and drama in particular and supported the Cambridge Arts Theatre financially, which allowed the institution to become, at least for a while, a major British stage outside of London.

Keynes had a fearsome reputation as a talented debater, and Friedrich von Hayek refused to discuss economics matters in person with him on several occasions. However, after reading Hayek's The Road to Serfdom Keynes said, "In my opinion it is a grand book....Morally and philosophically I find myself in agreement with virtually the whole of it: and not only in agreement with it, but in deeply moved agreement." Hayek says that this is "because Keynes believed that he was fundamentally still a classical English liberal and wasn't quite aware of how far he had moved away from it. His basic ideas were still those of individual freedom. He did not think systematically enough to see the conflicts."[1] Bertrand Russell named Keynes as the most intelligent person he had ever known, commenting: "Every time I argued with Keynes, I felt I was taking my life in my hands".

Education

Keynes enjoyed an elite early education at Eton, where he displayed talent in a wide range of subjects; particularly mathematics, classics and history. His abilities were remarkable for their sheer diversity. He entered King’s College, Cambridge, in 1902, to study mathematics, but his interest in politics led him towards the field of economics, which he studied at Cambridge under A.C. Pigou and Alfred Marshall. Marshall is believed to have prompted Keynes's shift in interest from mathematics and classics to economics. Keynes recieved his B.A. 1905 and his M.A. in 1909.

Career

Keynes accepted a lectureship at Cambridge in economics funded personally by Alfred Marshall, from which position he began to build his reputation. Soon he was appointed to the Royal Commission on Indian Currency and Finance, where he showed his considerable talent at applying economic theory to practical problems.

His expertise was in demand during the First World War. He worked for the Adviser to the Chancellor of the Exchequer and to the Treasury on Financial and Economic Questions. Among his responsibilities were the design of terms of credit between Britain and its continental allies during the war, and the acquisition of scarce currencies.

At this latter endeavor Keynes’ “nerve and mastery became legendary,” in the words of Robert Lekachman, as in the case where he managed to put together — with difficulty — a small supply of Spanish pesetas and sold them all to break the market: it worked, and pesetas became much less scarce and expensive. These accomplishments led eventually to the appointment that would have a huge effect on Keynes’ life and career: financial representative for the Treasury to the 1919 Paris Peace Conference.

Keynes' career lifted off as an adviser to the British finance department from 1915 – 1919 during World War I, and their representative at the Versailles peace conference in 1919. His observations appeared in the highly influential book The Economic Consequences of the Peace in 1919, followed by A Revision of the Treaty in 1922. He argued that the reparations which Germany was forced to pay to the victors in the war were too large, would lead to the ruin of the German economy and result in further conflict in Europe. These predictions were borne out when the German economy suffered in the hyperinflation of 1923. Only a fraction of reparations were ever paid.

Keynes published his Treatise on Probability in 1921, a notable contribution to the philosophical and mathematical underpinnings of probability theory. He attacked the deflation policies of the 1920s with A Tract on Monetary Reform in 1923, a trenchant argument that countries should target stability of domestic prices and proposing flexible exchange rates. The Treatise on Money (1930) (2 volumes) effectively set out his Wicksellian theory of the credit cycle.

His magnum opus, the General Theory of Employment, Interest and Money challenged the economic paradigm when published in 1936. In this book Keynes put forward a theory based upon the notion of aggregate demand to explain variations in the overall level of economic activity, such as were observed in the Great Depression. The total income in a society is defined by the sum of consumption and investment; and in a state of unemployment and unused production capacity, one can only enhance employment and total income by first increasing expenditures for either consumption or investment.

The total amount of saving in a society is determined by the total income and thus, the economy could achieve an increase of total saving, even if the interest rates were lowered to increase the expenditures for investment. The book advocated activist economic policy by government to stimulate demand in times of high unemployment, for example by spending on public works. The book is often viewed as the foundation of modern macroeconomics. Historians agree that Keynes influenced U.S. president Roosevelt's New Deal, but disagree as to what extent. Deficit spending of the sort the New Deal began in 1938 had previously been called "pump priming" and had been endorsed by President Herbert Hoover. Few senior economists in the U.S. agreed with Keynes in the 1930s. With time, however, his ideas became more widely accepted.

In 1942, Keynes was a highly recognized economist and was raised to the House of Lords as Baron Keynes, of Tilton in the County of Sussex, where he sat on the Liberal benches. During World War II, Keynes argued in How to Pay for the War that the war effort should be largely financed by higher taxation, rather than deficit spending, in order to avoid inflation. As Allied victory began to look certain, Keynes was heavily involved, as leader of the British delegation and chairman of the World Bank commission, in the negotiations that established the Bretton Woods system. The Keynes-plan, concerning an international clearing-union argued for a radical system for the management of currencies, involving a world central bank, the Bancor, responsible for a common world unit of currency. The USA's greater negotiating strength, however, meant that the final outcomes accorded more closely to the less radical plans of Harry Dexter White.

Keynes wrote Essays in Biography and Essays in Persuasion, the former giving portraits of economists and notables, whilst the latter presents some of Keynes' attempts to influence decision-makers during the Great Depression. Keynes was editor in chief for the Economic journal from 1912. He was also a member of the Liberal Party.

Investor

Keynes' brilliant record as a stock investor is demonstrated by the publicly available data of a fund he managed on behalf of King's College, Cambridge.

From 1928 to 1945, despite taking a massive hit during the Stock Market Crash of 1929, Keynes' fund produced a very strong average increase of 13.2% compared with the general market in the United Kingdom declining by an average 0.5% per annum.

The approach generally adopted by Keynes with his investments he summarized accordingly:

A careful selection of a few investments having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time;

A steadfast holding of these fairly large units through thick and thin, perhaps for several years, until either they have fulfilled their promise or it is evident that they were purchases on a mistake, and;

A balanced investment position, i.e. a variety of risks in spite of individual holdings being large, and if possible opposed risks (e.g. a holding of gold shares among other equities, since they are likely to move in opposite directions when there are general fluctuations).

Keynes argued that "It is a mistake to think one limits one's risks by spreading too much between enterprises about which one knows little and has no reason for special confidence ... One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself to put full confidence."

Keynes' advice on speculation, some might say, is timeless:

"[Investment is] intolerably boring and over-exacting to any one who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll."

When reviewing an important early work on equities investments, Keynes argued that "Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus there is an element of compound interest operating in favor of a sound industrial investment."

Main Contributions to Economic Thought

In his magnum opus, The General Theory of Employment, Interest, and Money, Keynes laid the foundation for the branch of economics termed "Macroeconomics" today. Based on the methods devised by Alfred Marshall, he argued that macroeconomic relationships differ from their microeconomic counterparts because the ceteris paribus clauses applicable to different levels of aggregation differ. The view that for given prices and wages income determines demand (see IS-LM), pre-dates Keynes. His innovation is to take, in his core argument, prices and wages as perfectly flexible and establish that the interaction of "aggregate demand" (in his sense) and "aggregate supply" (in his sense) may lead to stable unemployment equilibria. His work on employment went against the idea that the market ultimately settles at a state of full employment - a central tenet of Classical economists. Instead he argued that there exists a continuum of equilibria, the full employment equilibrium position being just one of them. (This idea underlies the choice of the title "General Theory": the classical theory being just a special case.)

His main contribution can be seen in establishing an approach to macroeconomics that maintains its relationship to the underlying microeconomic behaviors, but assumes a form qualitatively different from microeconomic models. (This contrasts with the assumption made in New Classical Economics where macro relationsships are modelled analoguously to micro-relationships, →Robert Lucas, Jr.). He maintained, however, many factually doubtful assumptions of standard theory. He assumed for instance that (marginal) labor productivity decreases with expanding employment. This is incompatible with the empirical findings summarized in Okun's Law. He combined this position with the marginal productivity theory of wages, implying that real wages decrease with increasing employment. This is empirically incorrect, as has been pointed out by the economist Dunlop, and the criticism has readily been accepted by Keynes. Further, Keynes suggested in the General Theory that inflation would occur only near "full employment" (in his sense), but it has been observed in many cases that inflation creeps up in states of severe underemployment (Stagflation). The erroneous assumption entertained by Keynes that inflation can only occur near full employment is still maintained in modern macroeconomics (→NAIRU). Keynes held that the cause of unemployment is a too high rate of savings, or insufficient investment expenditure. He conjectured that the amount of labor supplied is different when the decrease in real wages is due to a decrease in the money wage, than when it is due to an increase in the price level, assuming money wages stay constant. This conjecture relates to the "actual attitudes of workers" and is "not theoretically fundamental," although the New Keynesian economics emphasizes this point.

In his Theory of Money, Keynes said that savings and investment were independently determined. The amount saved had little to do with variations in interest rates which in turn had little to do with how much was invested. Keynes thought that changes in saving depended on the changes in the predisposition to consume which resulted from marginal, incremental changes to income. Therefore, investment was determined by the relationship between expected rates of return on investment and the rate of interest.

In 1944, Mount Washington Hotel hosted the United Nations Monetary and Financial Conference also known as the Bretton Woods International Monetary Conference. Delegates from 44 nations convened, establishing the World Bank and International Monetary Fund, setting the gold standard at $35.00 an ounce and designating the United States dollar as the backbone of international exchange. Keynes was leader of the British delegation. The signing of the formal documents took place in the Gold Room, located off the Hotel Lobby and now preserved as an historic site, creating the Bretton Woods system. This system partly ended with the Nixon Shock.

Death

Keynes died of infarction, his heart problems being aggravated by the strain of working on post-war international financial problems. John Neville Keynes (1852 – 1949) outlived his son by three years. Keynes' brother Sir Geoffrey Keynes (1887 – 1982) was a distinguished surgeon, scholar and bibliophile. His nephews are Richard Keynes (born 1919) a physiologist; and Quentin Keynes (1921 – 2003) an adventurer and bibliophile.

Influences on Keynes' works

Arthur C. Pigou

Alfred Marshall

Adam Smith

David Ricardo

Karl Marx

Thomas Malthus

Keynes' influence

Keynes appeared on December 31, 1965 edition of TIME magazine.

Keynes' theories were so influential, even when disputed, that a subfield of Macroeconomics called Keynesian economics is further developing and discussing his theories and their applications. John Maynard Keynes had several cultural interests and was a central figure in the so-called Bloomsbury group, consisting of prominent artists and authors in Britain. His autobiographical essays Two Memoirs appeared in 1949.

Critique

While Milton Friedman describes The General Theory as 'a great book', he argues that its implicit separation of nominal from real magnitudes is neither possible nor desirable; macroeconomic policy, Friedman argues, can reliably influence only the nominal.[2]. He and other monetarists have consequently argued that Keynesian economics can result in stagflation, the combination of low growth and high inflation that developed economies suffered in the early 1970s. More to Friedman's taste was the 1923 Tract on Monetary Reform, which he regarded as Keynes's best work because of its focus on maintaining domestic price stability.[2]

Friedrich von Hayek reviewed the Treatise on Money so harshly that Keynes decided to set Piero Sraffa to review (and condemn no less harshly) Hayek's own competing work. The Keynes-Hayek conflict was but one battle in the Cambridge-LSE war.

Ludwig von Mises

Murray Rothbard's essay Keynes, the Man[1], a scathing attack on both Keynes' economic theories and personage.

Rational expectations

Henry Hazlitt has written a book entitled The Failure of the New Economics, a detailed chapter-by-chapter critique of Keynes' "General Theory" [2]

Roger W. Garrison author of Time and Money: The Macroeconomics of Capital Structure and other works